Economic Recovery Is on the Horizon

Mark Zandi, an economist, called from the airport in Orlando with news: “The fundamentals of the U.S. economy are better than they have been in 15 to 20 years.” As Zandi was delivering his ebullient tidings, the stock market was crashing for the third time in a week, on this day an awful 520 points. Proximity to Mickey Mouse can induce an undue feeling of cheeriness, but Zandi showed me the figures. American households have pared their debt—significantly. Corporations are rolling in cash. Banks are profitable and far better capitalized. By the way, even our government looks better than those across the pond. We have a central bank that responds to emergencies with purpose and vigor and a Congress—yes, a Congress—that wrote a bailout check when it was required. None of this has occurred in Europe, or will.

So before we get to all that went wrong—a debt-ceiling fiasco, a downgrade of America’s credit by Standard & Poor’s, Wall Street panic—it is worth pointing out that comparisons to 2008 are silly. Lehman Brothers is history; the run of failing banks will not be repeated. Nor are investors worried, per se, about a government default. Money is pouring into dollar assets. When the Treasury can borrow at just over 2 percent, it means lenders think they will be repaid.

Nonetheless, Standard & Poor’s (which the administration foolishly blamed) performed a public service in sounding an alarm. It matters not whether the rating is “correct”—credit ratings are opinions about the odds of default. Routinely, they will be wrong. What matters is that S&P trumpeted a problem too long ignored. While private purses are on the mend, the federal budget has imploded. Part of this was deliberate—a response to the mortgage crisis and the recession. You can think of the stimulus, TARP, and the Fannie and Freddie bailouts as part of a process by which debts were transferred from a sick private sector to the public. Even at the price of temporarily harming its own finances, government had to provide the fix.

But S&P wasn’t faulting the U.S. for patching the mortgage mess. S&P was reacting to the more systemic cause of America’s budget problems—which are momentous. This cause, S&P noted, is “political,” though “ideological” would be a better word. It springs from a fantasy of the Republican right that has been embraced by the U.S. Congress for fully a decade. This is the fantasy that governments can operate without revenue—more precisely, that a government presiding over an expanding economy as well as an aging population can operate without increases in revenue.

Ever since the Bush-era tax cuts of 2001 and 2003, the government has suffered from self-induced anorexia. Those oft-debated but never rescinded tax breaks have steadily drained the Treasury and added to its borrowings. Consider that in 2000, the total U.S. government debt (the net accumulation of its borrowings since the Revolutionary War) was $3.4 trillion. Today it is $11 trillion. This matters now because with the economy slowing again, the debt hugely constricts our options. The normal response to the bad jobs market would be increased deficit spending, but the government is already operating at a $1.5 trillion annual deficit (that’s equal to a tenth of the GDP). It is borrowing half of what it spends. That’s enough to have spooked S&P and reminded the stock market a bit too much of Europe.

You can understand the budget by thinking of two parallel lines, one representing spending, the other revenue. During most of the postwar period, the spending line was a shade higher (the government typically ran small deficits). In 2001, when the budget last was in balance, the government collected roughly 19 percent of the GDP in taxes; it spent slightly less. But since the Bush tax cuts went into effect, the lines have wildly diverged. Spending has soared to 25 percent of GDP. And, alarmingly, tax receipts have crashed to 15 percent of GDP, the lowest level since World War II. Everyone, Democrats included, recognizes that spending must come down. But the Republicans insist that taxes—any taxes—are off limits. Regrettably, Obama has mimicked this position with a populist twist (he opposes reversing the tax cuts except on the “rich,” whom he defines as people earning more than $250,000 a year). Though coated in progressivism, this extends the myth that people can get something for nothing.

It’s hard to overstate the extent to which these cuts have been, and continue to be, the worm in Uncle Sam’s apple. They have cost the U.S. $3 trillion; the stimulus, by contrast, cost $1 trillion. If the cuts are extended, over the next decade they will bleed the Treasury of $5.4 trillion more.

Obama had a chance to let them expire in 2010; he blew it. He has another chance after the 2012 election. This time Obama should let them expire; indeed, he should campaign on a platform of achieving budgetary sanity via adjustments on both taxes and spending. The Republicans will repeat their pledge of no taxes. Let’s see who wins.

Obama could point to the following numbers: U.S. debt held by the public was 32 percent of GDP when Bush took office. Now it is 72 percent. If the cuts expire, the ratio stays flat, according to the Center on Budget and Policy Priorities. But if the cuts are reinstated, the ratio soars to 95 percent by 2021. At that point, America should join the EU, because we will look like Europe (a point that should go over big in the red states).

Deficit doves will say the economy still needs stimulus. They are right that anti-recession measures such as the reduced payroll tax should be extended. If employment doesn’t pick up, I would favor a targeted jobs program, too. But a little patience is in order. The economy is sluggish because consumers have been repaying their debts. That always takes time after a financial crisis. The good news is, the typical household’s debt service, as a percentage of income, is now nearing record lows. Mortgage debt is still falling, but credit-card borrowing is ticking up. Translation: spending should pick up soon. (And note: letting the tax cuts expire will not mean Hoover-style prudence; we would still be running big deficits.)

The larger point is that federal programs must be paid for. Taxes are the friend of responsive government—without revenue, government is merely a shell game. That kills confidence—it already has—and freezes investment and jobs. Eventually, it buries the economy in debt. But if you combined expiration of the tax cuts with phased-in cuts on entitlements, plus the smaller budget cuts Congress just legislated, and wipe out freebies like the mortgage deduction, the budget could be fixed. And that’s no fantasy.